Never be a bull or bear because it’s fashionable. Trades are based on fundamentals and technicals—–not popular rumors.
Harry Markowitz received the Nobel Prize for economics for his theories of modern portfolio tactics, which highlight new and better methods of controlling risk. In his Modern Portfolio Theory (MPT) he starts out by assuming all investors are risk averse and defines risk as a standard deviation of expected returns.
I studied Markowitz’s theories in great depth back in the early 2000s and came to the conclusion that the difference between his thinking and previous other portfolio theories is he believed that, instead of measuring risk for a specific share, risk should be measured at the portfolio level.
Therefore, each individual investment should not be examined on the basis of its individual risk, but on the contribution it makes to the entire portfolio.
Markowitz also believed it is important to assess how investments can be expected to move together or, said differently, how investments correlate to one another. Today, many portfolio managers use his portfolio techniques for asset classes instead of individual stocks; thus constructing globally diversified portfolios.
At the risk of sounding presumptuous, I believe that traders need to take that theory and enhance it by one additional step. Traders should assess both individual shares and the portfolio as a whole.
In essence, if a single position falls below a stop loss, do you sell that stock if the overall portfolio is still substantially up? Keep this in mind as we draft the three portfolios of professional traders.
Over the past 30 years, research techniques and portfolio management systems have changed radically. If traders are to survive in a globalized and electronic world, and soon to become 24 hours a day trading exchanges, it is important to understand the influence of globalization on portfolios and also a few basic concepts from the past.
A quick note on some key globalization points influencing traders:
• Capitalism and free markets are the greatest wealth-creating mechanisms ever devised and stock markets adopt this stance to economics.
• As entrepreneurs and traders go about serving their own interests, the value of the world’s economy increases.
• Markets, which are an integral part of capitalism, rise to reflect the increase in the world’s economy.
• This trend is expected to continue.
• Markets offer all investors and traders the best opportunity to participate in the growth of the global economy.
• Risk should not be avoided, because it offers traders opportunities to participate in new companies, aiding them to grow and thus offer higher returns.
• Equities offer investors the highest real returns over time.
• Most investors and traders cannot expect to meet their reasonable goals without accepting some level of market risk.
• The impact of market timing and individual security selection pale by comparison to asset allocation and strategy.
• Risk can be actively managed.
• Diversification is the primary protection for traders and investors alike.
• Asset allocation between shares, bonds, cash, and derivatives allow investors and traders to tailor portfolios to meet their risk tolerance.
• MPT offers investors and traders the chance to attain efficient portfolios that maximize their returns for each level of risk which they are able to bear.
• Investors must accept and expect reasonably regular market declines, which are natural.
• It is vital traders maintain a long-term perspective and exercise discipline with every trade they make.
• Markets are efficient and attempts to time the market have not been effective or reliable methods of enhancing returns or reducing risk.
• Active management cannot demonstrate sufficient value add to offset their increased costs.
• The world economy is expanding, but the world’s stock markets will continue to be an efficient mechanism to capture this growth in securities’ value.
• Past performance of investment managers is not a reliable indicator of expected future performance.
• Cost is a controllable variable in investment management. Low cost is strongly correlated to higher investment returns. Management fees, transaction costs, and taxes all serve to reduce investor return. Costs must be rigidly controlled.
Portfolio Lessons from the Past
Lesson 1: Portfolio versus Economics
• Traders operate in a world that is continually changing and must thus accept that few variables are under their control if they are to succeed.
• Economists often precede forecasts with “all things being equal,” which means their forecasts are based on variables not changing in the near future. Traders have to adopt the opposite stance using a phrase like “having taken numerous possible risks into account etc.” Changing variables does not mean that you cannot develop a sound, long-term strategy to build a portfolio.
• In essence, a sound strategy is one that assesses risk and rewards to maximize returns, which, over time, helps build skills and experience. When you start a portfolio, you will make mistakes until you learn your lessons.
Lesson 2: Equities Are Sound Investments
• While many countries’ exchanges enable traders to invest across borders, many traders have not changed their local asset allocations to a global asset allocation. This is a long-term strategy in which traders divide their available wealth among the world’s desirable asset classes.
• The first task is to decide on which assets to include or exclude.
• The last 20 years have been good to equities globally, but political risk has played a major role in converting many traders into speculators. During this period, there was low inflation, high inflation, booms, recessions and depressions, high and low interest rates, war, civil unrest, and violent natural disasters. Currencies around the world were weak, then strong and stock markets around the globe boomed and crashed several times during this period (see annexures). In short, traders had plenty to worry about when going through these times, but also plenty of opportunities to trade securities.
• This period has seen portfolios change and today’s investment structures are designed with the leading edge of financial and market research. However, traders should continually assess new and possibly better investment and portfolio tactics. As new tools are developed, these will usually first be available to large institutions and investment advisors, but it is only a matter of time before they are available at local retailers.
Lesson 3: Numbers Can Be Deceiving
• Traders and investors alike must be conditioned to think of market timing, stock selection, and portfolio performance as fundamental keys to success. These beliefs are often deeply ingrained in novice traders, who are afraid of even superior investment returns in a strategic global asset allocation, so it will take some time for these voices to get used to global trading.
• Traders should be aware that globalization necessitates a radical change in the way portfolio managers and traders operate. For instance, investment advisors are expected to have an opinion on where the market is going and, therefore, investors and traders look to these “experts” for advice. The problem is that the market is saturated with financial experts.
• Through the media, investors are exposed daily to countless different opinions about the market, trends, and recommendations. They tell investors to retreat to the safety of cash or gold, which allows these experts to look responsible and conservative. In addition, often the first question people will ask is: “What was your performance last year?” Those numbers become the chief yardstick to determine whether the advisor is good or bad. Very seldom will the trader ask: “What’s the best trading allocation?” or “How much risk do I need to take to meet my goals?”
• In a global market, traders can diversify between countries and not only sectors. The following example highlights the problem of using growth rates as the chief yardstick:
Mr. D. Kennedy has $1 million invested in a newly listed company on the NYSE, called ABC Ltd. At a price of $1 a share, he owns one million shares in ABC Ltd. In the first year of operation, the company landed a multibillion dollar contract with neighboring states to set up satellite stations. By the end of the first year, the company’s share has moved to $2.20 a share and Kennedy has achieved a return of 120 percent on his investment.
Mrs. L. George had $1 million invested in the Far East and shifted her funds to first-world markets just before the 1997 stock market crash. Her portfolio looks exceptionally bright, showing a 40-percent return on a share that climbed from $100 a share to $140 a share.
These shares show phenomenal returns. Yet both sets of figures distort the true nature of the return on these investments. Kennedy’s investment return is off a low base and the longer he holds the share the worse his investment return (in percentage terms) will become.
For instance, if the share rises by another 120 cents in the next 1 year, the share will have climbed to $3.40, which is an increase of 54 percent. Another 120 cents in Year 3 will mean a share price of $4.60, which is an increase of 35 percent.
To use percentage increases as a yardstick brings its own problems. That is, off a low base the company has to continually increase earnings to achieve the same rate of capital return. This is an impossible task in the short term, but if the investor had bought the share for the long term then he or she could see the share rise to $6, which means he or she would have achieved a 500-percent rate of return.
George’s investment is off a high base and a 40-percent return is substantial. However, she will be hard pressed to find another investment that will offer a 40-percent return in the next 1 year.
If the investor is told by a portfolio manager that a company’s attributable profit has climbed by 30 percent, the investor must insist on the base that this percentage is made. For instance, if the company had a profit of $1 million in Year 1 and $1.3 million in Year 2, this is very different to a company that has a 30-percent growth rate of a base of $1 billion in Year 1.
If the number is in the low figures (thousands or low millions) then it can be said “the company achieved a 30-percent growth off a low base of $1 million.” If the amount is in the high millions or in billions then it can be said that “the company achieved a 30-percent growth off a high base of $1 billion.”
Summary: It is more prudent to concentrate on a portfolio’s long-term potential than on short-term gains. This does not mean investors should miss out on market aberrations. Set aside portions of funds to speculate, but do not use the entire portfolio.
Without tools to evaluate risk or choose between alternative strategies, investors often feel they are left with just one number to compare performance; year-to-date or last year’s performance figures are the only criteria for measurement. If investors believe those figures alone determined a successful investment plan, they should buy the previous year’s top-performing unit trust and ignore market signals. Unfortunately, this approach is often the worst way to form a strategy.
Lesson 4: Change Is the Only Constant
Building a successful investment plan to meet globalization head on will require a fundamental change in the way investors think about strategy and performance objectives. The word strategy implies a conscious effort to achieve stated goals. Their concern should be to at least meet their minimum acceptable return levels without taking excessive risk.
The way an asset-allocation is designed will determine returns for short- and long-term periods. In addition, risk and returns will be driven more by the investor’s asset allocation than by individual share selection or market timing. Any asset class can and will have extended periods of significant underperformance from its long-term trend.
Similarly, there will be periods when the portfolio will outperform the market trend. Of course, investors can play it safe and stay with mutual funds or unit trusts, or they can have some risky assets in their portfolios. Why have risk-related shares?
Lesson 5: Embrace Risk
The reason is this: When risk is measured at the portfolio level, a risky asset with a low correlation to other assets in the portfolio can actually reduce risk in the portfolio. A diversified portfolio offers much higher returns per unit of risk than does a single blue chip share.
Over the long term, investment markets and portions of markets generally sort themselves out. In the short term, it is not unusual to see a negative sloping, risk-reward line, that is, the market fell and shares underperformed relative to bonds or T-Bills. The investor with a long-term return objective must know that down (and up) swings exist, but these are always temporary and have little impact on the way to meeting your goals.
Statistically, penny shares have a higher return and risk than second liners or blue chips. For the aforementioned reasons, it is never safe to talk about a company’s performance in terms of percentage rates. In the international arena, even size of companies becomes relative.
In addition, emerging nation stocks have a high return profile, but also high risk. These are primarily large growth areas, but they also fall considerably below the large first-world blue chip stocks when a crisis hits emerging markets. This was amply highlighted during the 1997 stock market crash.
Note: What is important is how much risk the portfolio has and that it is reasonably conservative. In addition, these volumes are about strategy, which also implies a long-term approach. Even the “best” long-term strategy will not be the best each year and since we are dealing with equities and associated risk profiles, it is important to understand that even the “best” strategy does not provide investors with a guarantee against occasional negative periods.
Lesson 6: Markets Do Decline
Investors often refer to risk as “the chance of the market falling.” There is no doubt that no one likes to see their shares decline in price, but if they are quality stocks, losses should ultimately turn into gains. It must be stressed that investors have to wait for the market to turn before gains are achieved. This comes only after a long-term period.
Investors also seem to have any number of mental yardsticks that they employ relentlessly either against themselves or their financial advisors during periods of underperformance. Investors not only want to outperform convertible debenture rates, but they want to do that every day. Here is a truism—not even a superior portfolio will outperform debenture rates every day or every year.
In other words, reality will rear its ugly head just when you think bull runs will continue forever. The last 30-year period has been characterized by falling interest rates, falling inflation and superior stock markets, but during this period there were also the dismal stock market corrections; see appendixes.
No one should base their planning on high returns every year. As a rule of thumb, investors should expect long-term results of about 8 to 10 percent above the inflation rate. If you do better, celebrate! Just do not base your whole strategy on attaining returns that are so much higher than normal.
Lesson 7: Trust in Your Strategy
Investors often have one more mental yardstick for comparison. The temptation to second guess yourself or your strategy is enormous. Investors are, after all, only human, and they believe, quite reasonably, that they should have it all.
Investors often tend to narrowly focus on any yardstick that is exceeding their portfolio performance for the moment. Unless investors can focus on their own goals, risk tolerance and strategy, performance becomes an impossible moving target. Investors must understand that a superior portfolio will underperform from time to time, no matter what mental yardstick they are using.
Lesson 8: Tailor Make Your Portfolio
Investors who desire higher risks and rewards can reduce the proportion of bonds in their portfolio. Once they get to zero bonds they have two potential courses to follow if they still want higher returns.
• First, they could shift the asset allocation to more value and small company stocks.
• Second, include emerging market stocks in their portfolio.
Lesson 9: Survival of the Fittest
There are a number of survival lessons, which are described as follows:
• Do not do totally insane things with your money. The Orange County disaster in the United States was the perfect example. Part of the portfolio was a derivative investment that underpinned how investors can make irrational decisions.
• Never borrow short and lend long. In fact, you should not borrow to make investments. Borrowing multiplies your risk. If you borrow $1,000 to buy $2,000 worth of stock, then you will double your original money (minus interest charges) if the stock rises by 50 percent. However, you will lose your entire stake if the stock falls by 50 percent.
• Make appropriate investments. A consultant must always be with a legally recognized stockbroker or institution. In addition, it is important to continually check your own finances and figures—never take anything at face value.
• Never have a preconceived scenario and fall in love with it. Never have an absolutely unshakeable belief that economic variable will move your way, that interest rates would continue to fall, and that shares will always be positive or negative.
• Never implement a strategy without an exit window. When providing a portfolio manager with an order to buy or sell shares, make sure there is a stop-loss technique, that is, always set a definite price (say, 20 percent below cost) for a sell order.
• Do not buy anything you don’t understand. If you do not understand future, commodity trading, warrants, derivatives or bonds—stay out!
• Don’t judge an investment simply by its track record. Some companies produce spectacular returns in the first 2 years of operation, but run into problems later on. The key for an investor is not merely to look at what has been done in the past, but to understand why the company has been so successful.
• In the market, no good thing lasts forever. This has been said many times, if you touch hot investments, you could get burned.
• Believe in amateur stock market sayings and see your portfolio die. These include:
Knowing which stocks to buy and when to be in the market is the key to investment success.
A good investor can predict which way the market is going and which stocks will profit the most.
This power is held by just a few wise men.
These wise men will readily share their power with you for a nominal cost.
Knowing when the market will fall is a prime concern to the successful investor.
One should leave the market when it is about to go down in order to preserve one’s principal investment, that is, the capital amount.
Successful investors trade often and dart in and out of the market or a particular stock with uncanny skill.
Their portfolios benefit from a hands-on approach.
It is easy to spot good companies through an examination of financial data and to determine what the stock in those companies should be worth.
An astute investor can apply superior insight to make big killings on underpriced stocks. Using his superior insight he or she will be able to take action long before other investors catch on.
Studying past price movements is an aid to predicting future price movements. This skill can be applied to both individual stocks and the movement of the market as a whole.
Economic predictions are reliable and form another strong foundation for success. It is reasonably easy to select good advisors and managers, because their past track record is a reliable indicator of future success and skill.
Given all that, many investors tend to think of the investment process in the following terms:
• What shares should I buy?
• Should I be in or out of the market now?
• When should I sell my stocks?
• Which manager should I hire? Or, what mutual fund should I buy?
• Unfortunately, almost all of this conventional wisdom is wrong. It does not do us any good to think of investing in these terms. In fact, it creates problems and keeps us away from enjoying the fruits of a game strongly tilted in our favor.
Chapter 13 investigates and highlights traditional portfolio theory.